A webinar organized by IPE was the stage to discuss the new paradigm in the way investors look at digital assets. It was also an opportunity to explore the recently launched STOXX^® Digital Asset Blue Chip index, which offers exposure to high-quality assets that represent the crypto universe today. 

“We are entering the era of digital assets maturity,” Loris Voneschen, Head of Index Business at Bitcoin Suisse, said during the broadcast. “The space is migrating towards more tangible use cases and less fixation on price volatility and speculation.” The amount of assets available and heightened interest from investors and institutions in the last couple of months “underly the importance of being able to navigate the digital assets space with know-how and experience,” he said.

_{Source: IPE webcast. Clockwise from top left: Ladi Williams at STOXX, Brendan Maton (moderator), Loris Voneschen from Bitcoin Suisse, Valour’s Johanna Belitz.}

New rules and inflows

The approval of the first spot bitcoin exchange-traded funds (ETFs) in the US this year has triggered a dash to invest in cryptocurrencies through regulated and transparent vehicles. The ten US spot bitcoin ETFs launched in January 2024 have attracted record inflows and have amassed total assets of nearly USD 50 billion.^[1] With more clarity in the regulatory landscape, many institutional investors are starting to include cryptocurrencies within their multi-asset funds. 

Johanna Belitz, Head of Nordics at Valour, which has recently introduced an exchange-traded product (ETP) listed on the Frankfurt Stock Exchange (FSE) tracking the STOXX Digital Asset Blue Chip index and using Bitcoin Suisse as crypto data provider, said the digital assets market is currently undergoing a “demand shock.” She estimated during the panel that demand for bitcoin is running at about ten times the amount that is actually being mined.

Amid such uptake, a blue-chip index can bring transparency, help standardize prices and enable institutional-level investment products in a quickly evolving and emerging market that was until recently little regulated, said Ladi Williams, Head of Thematic and Strategy Index Product Management at STOXX. There are over 2 million digital assets trading in more than 700 venues, according to CoinMarketCap. 

“An index is an important tool that allows us to measure, understand and participate in a particular asset class or segment,” said Ladi. “In order to do that, an index has to have certain characteristics: it has to be representative of the asset class or segment, it needs to be rules-based and transparent, and if the intention is for it to underlie an investment product, it has to be investable.”

A quality focus

The STOXX Digital Asset Blue Chip index was designed with a focus on quality, rather than market capitalization as it is customary with other indices. The index considers crypto-native metrics including age, total value scored, developer community, active addresses and economic activity.

The list of eligible assets for the index is derived from the Bitcoin Suisse Index Reference Classification List (xRCL). Basic screening criteria trims the universe, with assets in the following five sectors from the Bitcoin Suisse Global Crypto Taxonomy (GCT) (Figure 1) then available for selection: Cryptocurrencies, General Purpose Smart Contract Platforms, Decentralized Finance (DeFi), Utility and Culture. 

Figure 1: Bitcoin Suisse Global Crypto Taxonomy

_{Source: Bitcoin Suisse. The ‘Tokenized Asset’ Sector is ineligible for the STOXX Digital Asset Blue Chip index, as is the ‘Privacy Coin’ Sub-sector.}

“The primary objective of the Bitcoin Suisse Global Crypto Taxonomy is to make the space more accessible for investors and the larger expert audience by offering a systematic structuring of the crypto industry,” explained Loris at Bitcoin Suisse.

Index constituents are selected in a screening process that considers the five crypto-native metrics mentioned earlier to rank assets in relation to their peer group. Those metrics give an idea of the quality, adoption, utility and financial strength of digital assets, in the same way metrics such as revenue and market capitalization define blue chips in the equities space.

Each digital asset gets an aggregated score based on those metrics, and those with the highest scores by sector make it into the index. This selection strategy draws parallels to the constitution of the flagship EURO STOXX 50^®, which is also comprised of Supersector leaders.

The index is finally weighted by market capitalization with a maximum cap of 30% at each quarterly review. This offers investors a true representation of the underlying market as well as exposure to smaller assets, but seeks to limit concentration in a few, dominant ones.

Figure 2: STOXX Digital Asset Blue Chip index methodology summary

_{Source: STOXX.}

Top holdings

The discussion turned towards the holdings in the STOXX Digital Asset Blue Chip index. The selection and weighting methodology seeks to capture the full opportunity set for investors in such a broad market, explained Ladi at STOXX. 

“A key characteristic of an index is its representativeness of the market,” Ladi said. “Bitcoin and Ethereum represent 70% of the market. These tokens’ weights (in the index) represent what you actually see in the market. In terms of having other assets as well, we have to be mindful of the fact that if you were to overweight those, they might not have the capacity to support the institutional inflows.”

Figure 3: STOXX Digital Asset Blue Chip index holdings

_{Source: STOXX. Holdings as of March 2024 review.} 

“There is both a diversification aspect as well as an attempt to capture bigger movements which you might not find in the top three digital assets, but lower down,” Johanna at Valour said about the index. “This is a very interesting aspect of basket or index products.” 

Exchange vetting and pricing

Pricing reliability is a big consideration for an asset class such as cryptocurrencies, which do not trade on exchanges that are as mature as traditional ones.

“It was important to make sure that the exchanges we are using for pricing have a level of scrutiny that is acceptable for our index,” said Ladi at STOXX. “That is where we lean heavily on Bitcoin Suisse’s expertise in order to come up with a pricing methodology that would reflect prices that investors are actually able to transact on.” 

Loris at Bitcoin Suisse explained that assets in the STOXX index are priced in a process that includes thorough exchange vetting. The data provider ranks crypto exchanges according to their scores based on security, legal, compliance and regulation, and financial criteria. The two highest-ranked venues measured by exchange score, adjusted for volumes and a decay-time factor, will provide the average price for the asset. Additionally, on a day-to-day basis, Bitcoin Suisse monitors the exchanges which are part of the eligible exchange universe.

Averaging the most recent traded asset prices across two sources ensures the most reliable, up-to-date and representative price. 

High returns, diversification

Towards the end, the panelists were asked about the outlook for cryptocurrencies, a hot topic given that bitcoin prices have jumped more than 70% so far in 2024.^[2] Johanna at Valour took the baton.

“We see very strong demand,” she said. “Also, we have the bitcoin halving coming up. Supply of new coins will be cut in half. It is a bigger risk to stand outside of the digital assets market than to take a position.” 

The webinar provided a great chance to understand the evolving state of play in the digital assets space and how investors can access the market through a systematic, index-based strategy that can help them navigate through the unknowns and challenges. 

^[1] Wall Street Journal, “Bitcoin Funds Pull In Money at Record Pace,” March 5, 2024.

^[2] Intraday prices through March 13, 2024.

But how can they screen out the best assets in terms of quality, financial clout and commercial activity? In other words, tokens that are akin to the blue chips of the equity world.

The STOXX^® Digital Asset Blue Chip Index was introduced last year and provides several tools for investors in the crypto world. Firstly, as a benchmark, it aims to act as a barometer of the underlying market’s behavior. Secondly, it helps navigate the space through a systematic and clear industry structuring as is the Bitcoin Suisse Global Crypto Taxonomy (GCT). The index also ensures asset price trustworthiness through a process that vets exchanges by volume and reliability. 

Finally, a comprehensive selection mechanism relies on crypto-native metrics to build a portfolio that is high-quality in the blue-chip sense, much like a similar equity portfolio will seek components with high revenues, established businesses, a large customer base and a solid balance sheet. 

Constructing a blue-chip crypto index

A new report^[2] delves into the STOXX Digital Asset Blue Chip Index’s asset selection process to unpick those metrics and understand the construction of a blue-chip benchmark in this segment. The asset characteristics considered in that process are:

Age: The age of a crypto asset helps gauge the commitment to the project and its adoption by the market.

Total Value Secured (TVS): The more value a protocol secures on its blockchain, the greater the trust, adoption and inherent applications the protocol has in securing transactions validity and immutability.

Active Addresses: The number of active addresses is used to measure adoption. This metric counts the number of unique sending blockchain addresses. 

Economic Activity: Strong fee revenue denotes usage and adoption, in addition to gauging the ongoing concern of the protocol and resilience in a competitive market landscape.

Developer Community: The developer community is a measure of innovative activity, growth and ossification at the same time. 

“Drawing direct analogies from the traditional equity markets while incorporating the intricacies of crypto is a challenge,” the report’s authors, led by Thomas Shuttlewood, Associate Principal for Product Research and Development at STOXX, write. “Blue-chip digital asset determination must consider the uniqueness of this distinct market, and must rely on criteria and fundamentals that are specific to the asset class.”

Sector leaders

For each metric, assets are assigned a score of 1 if they rank within the top 50% in their respective use-case sector: Cryptocurrencies, General Purpose Smart Contract Platforms, Decentralized Finance (DeFi), Utility and Culture. Those with a score of 4 or more are selected as constituents of the index.

Sector representation is an important consideration in benchmark creation and in representing the underlying economies and universe of the targeted asset class. To translate this notion into the digital asset space, one must rely on taxonomies that have been specifically created for this market, the authors explain. In likening crypto use cases to traditional industry sectors, one can select the leaders from each use-case sector into the index in much the same way as in the EURO STOXX 50^® design. 

Risk and returns

The authors then turn to analyzing the risk and return performance of the STOXX Digital Asset Blue Chip Index. The findings show that the index acts as a true reflection of the nature of the market, matching the average constituent return closer than any single component. In posting lower volatility than its individual components, the index’s standing as a blue-chip gauge is also enhanced. “A middling to strong returns for a relatively low level of volatility indicates that the index acted in a manner associated with a traditional blue-chip index in a defensive market regime,” the authors write.

Interest in the digital asset market is likely to continue gathering pace, so transparent and reliable data is vital. The space must be considered with the same respect as other asset classes, while still ensuring that its intricacies are included in the equation, the authors argue. An investment vehicle and market barometer in the shape of a blue-chip index allows this to happen. 

We invite you to download the report and explore its findings.

^[1] Source: CoinMarketCap.

^[2] “STOXX Digital Asset Blue Chip Index: A Benchmark for the Crypto World,” STOXX, March 2024.

Regulation aimed at limiting investment risk was a key driver in the launch of exchange-traded futures and options in the past two decades. However, the trend has most recently been underpinned by asset owners’ differentiating strategies, and the tailoring of indices to target them, the panel said.

“It’s a demand-supply question,” Serkan Batir, Global Head for Product Development and Benchmarks at STOXX, said during the discussion. The buy-side is “seeking new returns and risk management” tools. “You have the benchmarks or plain-vanilla indices which have been in the space for quite a long time but now we are seeing customization in that exposure. And those are the indices that will end up having futurization,” as market participants “seek new returns, and go for more precision and niche exposures.”

_{Eurex Derivatives Forum}

The 2008 global financial crisis prompted regulators around the world to limit the risk that asset owners and intermediaries take when entering positions, boosting volumes in the listed derivatives market. The segment of dividends derivatives, in particular, was highlighted during the panel as an example where liquidity has moved on-exchange, bringing plenty of benefits to traders and investors.

Over 5 million contracts in EURO STOXX 50^® Index Dividend futures traded on Eurex in 2023, for a notional volume of EUR 72 billion. The EURO STOXX 50 is at the center of an ecosystem that includes options (including daily expirations), futures and total return futures on the index, its dividends and its volatility. About 246 million EURO STOXX 50 index futures and 253 million EURO STOXX 50 index options traded in 2023 on Eurex. The Eurozone blue-chip benchmark is also a popular underlying for ETFs, with USD 33.3 billion currently invested in the funds^[1].

Hedging risk

Speaking at the Eurex event, Wilrik Sinia, Director at Mint Tower Capital Management in Amsterdam, described how the advent of listed dividend futures dramatically changed trading, from cumbersome phone negotiations with heightened counterparty risk “to a very automated process.” 

In the past, the amount of risk taken by traders would be out of sync with the size of the trade, Wilrik said. These days, however, products such as EURO STOXX 50 dividend futures allow participants to hedge every single risk source in the market, including market, dividend, earnings and repo risk, he said.  

This targeted exposure is what makes dividend futures an “incredible” alternative to company shares, and dividends an asset class in themselves, Gabriel Messika, Head of Index Forward Trading Europe at J.P. Morgan, told the audience.

“When you have a view on the earnings of a company, it’s a lot easier and clearer to express that view with dividend futures and options other than the share price itself, which moves with a lot of other reasons than earnings,” Gabriel said. 

All speakers agreed that the more liquidity flows into on-exchange trading, the more risk market participants can take.  

The future of futurization

Lorena Dishnica, Product Manager for equity and index at Eurex, mentioned the recently launched mid-curve options on EURO STOXX 50 index dividend futures as an example of innovation. She said the exchange is looking to add so-called swaptions on single stocks, and mentioned the STOXX^® Europe 600 index as an index whose trading ecosystem could be expanded as it’s happened with the blue-chip EURO STOXX 50. In the future, derivatives could also track companies’ earnings-per-share, she added.  

Wilrik at Mint Tower and Gabriel at J.P. Morgan said they expect higher volumes and more product innovation in the total return futures market.  

‘Outsourced product developer’

As pension funds and insurers review their liabilities, Serkan at STOXX said the role of index providers has also evolved with the need to customize strategies and to bring them onto a regulated market. 

“Twenty years ago we were simply an index provider,” he said. “Now we are more of what I call an outsourced product developer.” If a client doesn’t have the resources and know-how in-house, an index provider can supply the necessary expertise to build solutions and investable products, Serkan explained. 

Today, indices are vital to the trading landscape, and they must be independent, reactive and “bullet-proof” in all market circumstances, Serkan added. 

“At the end of the day, the sell-side and the buy-side are using the index to hedge their dividend, interest rate, collateral and volatility risk, and all that is embedded into one index,” he said. “That index needs to work no matter what happens,” he said, in reference to corporate actions within constituents, such as dividend cancellations.

^[1] Source: Morningstar, data as of February 2024.

These three trends combine to drive product design as indexing takes center stage over so-called active investing.

“Indices used to be performance measurement tools,” Axel Lomholt, General Manager at STOXX, said during the panel entitled ‘Index Leaders.’ “That’s not the way the world is operating anymore. It’s moved to a hyper-customized interaction with clients. You need to build an ecosystem that can cope with that customization that clients demand.”

_{Eurex Derivatives Forum 2024}

Driven by heightened regulation, new responsible-investing objectives, and a changing macroeconomic backdrop, institutional investors are seeking solutions that are both tailored and can efficiently help them achieve their very precise targets. Most noticeable within this new paradigm has been the integration of sustainability considerations as a pillar of portfolio construction, the panel concurred.  

“We’ve moved from a framework where clients were focusing on risk and return, to focus on risk, return and the real-world impact of the portfolio,” said Axel at STOXX. “We’ve seen not only customization within an index, but clients want to have a customized ESG overlay.”

ESG 2.0

Tom Jenkins, Head of Strategy at FTSE Russell’s Index Investments Group, agreed that those impact considerations have become more deeply engrained in portfolio construction in recent years. While the first sustainability indices focused on removing controversial companies, the new generation integrates ESG considerations more positively.

“If you are very generic, ESG 1.0 was an exclusionary exercise, and we really need to have more of an inclusive exercise,” Tom said. In “ESG 2.0,” clients want indices that look at a company’s management quality, its green revenues and its sustainability performance relative to peers, and reward the impact leaders, he said. “An index that says, here is a model behavior, here is one who is in-flight, and here is one who hasn’t started the process.” 

Two immediate challenges arise from this new bespoke trend, the panel said. The first one is how to implement sophisticated methodologies without losing the transparency of indices, a key attribute underpinning the global shift of capital to index-based investments. 

“Transparency is a huge component of our collective businesses,” said Tom at FTSE Russell. “If a product is opaque, it is not helpful to the investment community. People need to understand how you reach a point in the final calculation, where the risk-reward is coming from, where the tracking error is being driven from. If you can’t articulate or show that in the public domain, it is really hard to get an option.”

“We also see increasing demand from clients,” added Maya Beyhan, Senior Director for Index Investment Strategy at S&P Dow Jones Indices. “They want to understand what goes on behind those ESG scores. ESG 1.0 was arguably more subjective, more aggregated, less detailed. Whereas now, clients want to know more.”

Investable ecosystems

A second challenge is the need to create liquid investment ecosystems around tailored indices, to help investors manage and hedge their positions.

“How do you take that customized idea and make it available to the masses?” said FTSE Russell’s Tom. “Asset owners want the completion of the ecosystem. So, it’s a push and pull all around.”

Some of those solutions have successfully progressed to exchange-traded markets. This year Eurex introduced futures on the STOXX^® Europe 600 SRI, an index with product-involvement exclusionary screens as well as filters to remove the highest-emitting companies and include those with the best ESG scores. DWS last November launched the first ETFs tracking the new ISS STOXX® Biodiversity indices, a suite that integrates nature-related risks and opportunities through a comprehensive approach. 

Diversification and 3D investing

The panel also touched upon diversification, a topic of utmost relevance these days as the traditional negative correlation between equities and bonds appears to have broken down.

As investors search for emerging asset classes to allocate capital to, index providers have been at work to determine whether those investments can be indexed with gauges that are tradable and representative of the underlying market.

Axel at STOXX said the traditional formula of investing 60% in stocks and 40% in bonds has changed to one where up to 20% is now invested in alternative assets.

“It’s a meaningful shift that impacts all of us,” said Axel. “When you look at that 20% bucket, it is crypto, private assets, infrastructure. All stuff that historically was not really the domain of index providers.”

Tom at FTSE Russell and Maya at S&P Dow Jones highlighted infrastructure, digital assets and carbon credit futures among investments that are getting more investor interest as they seek to diversify exposures.

“The big thing in diversification is: it’s not about the risk and returns of all those asset classes, but it’s how does this portfolio impact the real world?” said Axel. “It’s 3D investing. For me, that is the biggest shift we’ve seen in years.”

Overall, the panel was an excellent opportunity to hear insiders’ perspectives in an industry immersed in change and shaping the way asset owners invest their capital. Index providers have become key partners for investment institutions as the latter adapt their portfolios to modern requirements. This partnership is likely to keep fostering innovation and bringing efficiencies in asset management. 

The three new Xtrackers ETFs track, respectively, the following indices:

• ISS STOXX^® Developed World Biodiversity Focus SRI
• ISS STOXX^® Europe 600 Biodiversity Focus SRI
• ISS STOXX^® US Biodiversity Focus SRI

We took the opportunity to get the perspective of the three parties involved in the design of the new products. Below is our exchange with Olivier Souliac, Head of Indexing at Xtrackers by DWS; Hernando Cortina, Head of Index Strategy at ISS ESG, which provides the biodiversity data; and Antonio Celeste, Director for Sustainable Product Management at STOXX.

Olivier, what was the driver behind the launch of the Biodiversity Focus SRI ETFs?

Olivier (Xtrackers): “There was not one but several drivers behind this project. The first one is local regulations and multilateral initiatives. There is a strong push from regulators to measure the impact on biodiversity of an investment, something that has been complemented by a number of initiatives such as the Science-Based Targets for Nature (SBTN) and the Taskforce on Nature-related Financial Disclosures (TNFD). Setting up the methodologies and the normative framework to understand, quantify and report the nature-related impact of an investment and of companies has enabled us to tackle the issue of biodiversity investing. Only then could we consider launching a product: only when you know how to measure, will you know how to improve.

A second driver has been the availability of an index-based response. What persuaded us to launch ETFs is that not only do we now have a framework but also an application of that framework — in the form of indices — based on credible datasets and a credible methodology.

The last factor is emerging demand for investments that address the financial materiality that comes with the loss of biodiversity. The sustainability offices of large investors such as asset owners have identified biodiversity risk as one of the next challenges that they want to address at a firm level in the near future.”

What are some of those risks for investors associated with biodiversity loss?

Antonio (STOXX): “Biodiversity loss has emerged as a key source of risk for investors and companies. The move to protect our habitats raises the regulatory liabilities for corporates and investors (for example, increasing legislation such as the banning of pesticides). This comes at a time when they are already facing biodiversity-related physical, transition and systemic risks. Physical risks include the loss of raw materials and the disruption of operating environments. Transition risks cover policy shifts, changes in market preferences and voluntary commitments. Systemic risks include the increased odds and breadth of global pandemics derived from ecosystem change.

Looking at the flip side, there are opportunities as well. Some companies are managing their supply chain and operations, and creating products and services with a positive impact on biodiversity.”

Antonio, can you describe the concept and process behind the ISS STOXX Biodiversity indices?

Antonio (STOXX): “The ISS STOXX Biodiversity framework has been designed as a holistic approach for investors to tackle those risks and opportunities described earlier. The ISS STOXX Biodiversity indices employ that framework and follow a multi-step process that approaches biodiversity through three different angles: Avoid (excluding companies that cause harm to biodiversity), Minimize (removing companies with the most negative biodiversity footprint), and Enable (tilting towards companies whose products and services aid biodiversity-related goals). An additional layer reduces the portfolio’s carbon footprint.

The framework can be applied to match investors’ specific preferences, integrating its steps and data on existing indices and strategies. For example, you can have a Paris-aligned benchmark and add a biodiversity layer on top of it. 

Our off-the-shelf offering includes two categories of ISS STOXX Biodiversity indices: the standard and the ‘Leaders’ indices. The latter have a more ambitious threshold in terms of exposure to biodiversity-related Sustainable Development Goals (SDGs), and select Sustainable Investment (SI) companies to ensure compliance with SFDR Article 9. But clients can customize their own products within our framework, as has been the case with DWS.”  

Figure 1 – ISS STOXX Biodiversity indices framework 

_{Source: STOXX.}

Why is it important to have different steps or layers to come up with a comprehensive biodiversity impact investment strategy?

Olivier (Xtrackers): “We think of this range as being a logical continuation of the core ESG ETFs that have come to market in recent years. It remains indeed focused on integrating sustainability risks. When you tackle biodiversity, you may want to integrate it within your existing sustainability agenda. In this sense, there are three key considerations related to biodiversity that Antonio already touched upon: the first one is the incorporation of Socially Responsible Investment-related exclusions (also integrating activities that are established to be controversial with regards to biodiversity, or “avoid”). The second factor that needs to be taken into account, and it is probably the most challenging, is the qualitative measurement of a company’s biodiversity impact. This is where the heart of the strategy lies. Here, adopting a traditional best-in-class strategy makes sense: just as you have low-carbon indices, you can obtain a lower biodiversity risk impact approach, where you don’t change the breadth and depth of the investment and you maintain the diversification and representativeness in terms of industry exposure.  

The last point touches upon company operations and revenues. Which is, to what extent the activity of a company supports certain SDGs linked to biodiversity. Here, removing worst-in-class companies adds a forward-looking element to the overall approach (the ‘Enable’ part).”  

Hernando, advancements in biodiversity data in recent years have been key to the design of the ISS STOXX Biodiversity framework. Where are we in the evolution of these datasets?

Hernando (ISS ESG): “ISS ESG has invested heavily in biodiversity data over the last couple of years, driven by both regulatory changes as well as underlying investor demand. Over this period, we have indeed seen a major evolution with more advanced and refined data. 

The focus of the data has evolved as well. The central element now lies in tying a corporation to its biodiversity impact, whereas before there was a more general focus on the products that a company makes or simply where it is located. We can now quantify more precisely the metrics that biologists and scientists have developed. 

The two most common metrics are the Potentially Disappeared Fraction of Species (PDF) and the Mean Species Abundance (MSA), both part of ISS ESG’s Biodiversity Impact Assessment Tool (BIAT). PDF quantifies the potential loss of species richness due to adverse environmental pressures, relative to species richness in undisturbed ecosystems. MSA quantifies the mean abundance of original species relative to that in undisturbed ecosystems. We are the only provider that currently delivers both PDF and MSA. 

We also have another subset of data within BIAT called Ecosystem Services. It allows us to know how dependent a company is on biodiversity to generate its products and services. 

That said, as an industry we are still at a relatively early stage in the biodiversity analytics process. Companies have only started to understand what they need to report. Currently, the data is all modelled. Over time, we hope to get more comparable data directly from companies. TNFD should be a significant accelerator of this process.” 

What are some results of integrating such datasets at a portfolio level, relative to a benchmark?

Hernando (ISS ESG): “Depending on the index, we can achieve reductions between 25% and 90% in overall PDF and a reduction of between 25% and 75% in PDF intensity. In addition, having a focus on biodiversity delivers side effects that are attractive to investors: for example, the strategy roughly halves the Scope 1 to 3 carbon intensity of the portfolio.” 

Figure 2 – ISS STOXX Developed World Biodiversity Focus SRI index results 

_{Source: STOXX. * Weighted Average Carbon Intensity = Sum[Wi * (Emissions Scope 1 + 2 + 3)i/ EVIC I]. Source: STOXX, as of December 2023.} 

Where do these ETFs fit in a typical investment allocation?

Olivier (Xtrackers): “These ETFs are part of our toolbox to help investors allocate capital in their core exposures, in compliance with their sustainability agenda. That is why we have three products that cover the core allocations of our institutional investors: Europe, the US and the developed world. We do not see these ETFs as being opportunity- or thematic-driven. On the contrary, they are primarily addressed towards our large institutional clients. As an example, a study we launched with CREATE-Research found that pension funds increasingly see it as their duty to contribute, on behalf of their pensioners, to mitigate the negative effects of past economic development on the environment, climate and biodiversity^[1]. In this context, we are looking at a core investment that benefits from global beta but that has reduced metrics with regards to environmental aspects such as carbon emissions and, now, the risk of biodiversity loss.” 

Some index constituents do not seem to have a clear biodiversity link. Why have they been selected?  

Hernando (ISS ESG): “The indices have been designed to deliver a diversified portfolio, so they exclude the highest-impact companies in every sector. As such, the methodology leaves companies that may not necessarily have a clear positive impact, but nonetheless this approach reduces the overall negative impact for investors and asset owners.
This step of the approach puts more focus on reducing harm than on supporting biodiversity-positive solutions. To address the positive aspect, the indices also include an important SDG overlay, seeking companies that have a positive impact on biodiversity-related SDGs.”

How do the indices correlate with the recently introduced TNFD recommendations? 

Antonio (STOXX): “That’s a very timely question. Last year’s TNFD recommendations set a roadmap to guide companies in integrating nature into their governance, strategy, risk and impact management, as well as metrics and targets. Importantly, the framework also supports financial institutions in portfolio construction and investment product development. It follows a broad action sequence (Avoid, Reduce, Restore, Regenerate, Transform) that is correlated to a high degree with the four-step index construction process at the core of the ISS STOXX Biodiversity indices framework (Avoid, Minimize, Enable, Decarbonize). So, to summarize, both STOXX and TNFD frameworks contemplate similar steps addressing the different degrees and types of biodiversity action.”   

Finally, Olivier, why did you choose ISS ESG and STOXX as partners in this project?

Olivier (Xtrackers): “We were very pleased to see that ISS ESG and STOXX were able to propose a comprehensive, institutional-grade assessment framework for biodiversity integration. And we were convinced by the quality of the PDF dataset, which had consistent outcomes and was broad enough in its coverage. We are also very familiar with the SDG-related datasets that are already in use in different portfolios at DWS. Biodiversity impact is an incredibly complex topic, and we needed the right expertise to tackle all aspects of it. The combination of STOXX and ISS ESG means you have established benchmarks with leading biodiversity datasets that you can apply as a core investment. This is something that the teams at STOXX and ISS ESG had been working on already, so it was a perfect fit for us. During the project, we also came to appreciate the constructive cooperation in developing our ETFs.”

^[1] DWS, “Study by DWS and CREATE-Research shows pension funds growing interest in impact investing,” September 1, 2022.

A new article published in The Journal of Beta Investment Strategies suggests that an optimized multi-factor strategy with low levels of active risk offers the potential to outperform the cap-weighted market. Drawing on data from the past 20 years, the authors — factor-investing experts at BlackRock, SimCorp and STOXX — show that multifactor strategies offer diversification at two levels: within factors and among the indi­vidual sub-components of each factor. Both help improve relative performance, backtest results indicate.

Evolution in factor investing

The study comes as investor demand for, and expectations from, factor strategies has evolved significantly in the past decade. As an example, the STOXX^® U.S. Equity Factor and STOXX^® International Equity Factor indices, launched in 2022, have tracking errors of around 1%, or roughly a fifth of that of single-factor indices introduced ten years earlier. 

Running the numbers on optimized factor portfolios

In “How Do Low Tracking Error, Multifactor ETFs Fit Into the Factor Investment Landscape?” BlackRock’s Andrew Ang, Bob Hum, Katharina Schwaiger and Lukas Smart; STOXX’s Anthony Renshaw, Hamish Seegopaul and Arun Singhal; and SimCorp’s Melissa Brown, analyze the performance of five single-factor portfolios and a multifactor one between March 2002 and June 2023.

The authors consider two parent universes: the STOXX^® USA 900 and STOXX^® Global 1800 ex USA indices. They select an alpha signal (a single factor, the multifactor signal^[1], or the individual components used to create the factors) and then construct a portfolio that maximizes its exposure to that alpha signal, subject to tracking error, turnover, active exposure, sector and country constraints. The single factors are Quality, Momentum, Value, Small Size and Low Risk. The optimization is performed using Axioma’s portfolio construction software.

The multifactor portfolio drawn from the STOXX USA 900 universe beat the Momentum, Value and Low Risk portfolios by around 1 percentage point per annum over the period (Table 1). Multifactor also significantly outperformed the Small Size factor portfolio, and came ahead of the Quality tilt only slightly. The multifactor portfolio’s Information Ratio (IR) was higher than all single-factor portfolios except for Quality. 

Table 1 – Performance Results 

_{Source: STOXX. Summary backtest active performance results for STOXX USA 900 index from March 2002 to June 2023.}

For the STOXX Global 1800 universe, multifactor also showed higher annualized returns over the period than all five single-factor portfolios considered, edging, for example, the Value and Low Risk signals by over 1 percentage point per year. The multifactor portfolio’s IR was higher than all single-factor portfolios.

“It is noteworthy that the multifactor case is at the top, or near the top, performance of all the portfolios constructed,” the authors write. “This is one of the advan­tages of multifactor indices, namely that they usually do well even when one or more of their underlying signals underperforms.”

As the authors note, the driving force behind this outperformance is diversification. Each of the underlying single-factor returns over the period shows low correlation with the others. 

“Through careful construction, multifactor indices can harness the diversification benefits amongst factors and signals,” the authors write, and “their associated premia can be efficiently harvested in a low tracking error format.”

Further, the authors explore how performance changed over the period considered by looking at the trailing 36-month, realized active returns of each factor strategy. Once again, the advantage of a multifactor approach becomes evident. Several of the single-factor portfolios — including Low Risk at different times, and Value and Small Size most recently — showed significant periods of underperformance. The multifactor portfolio, on the other hand, did not exhibit any sustained underwater periods.

Intra-factor diversification

A final consideration involves the construction of individual factors. Just as the combination of styles in a multi-factor portfolio can perform better than the average of their individual contributions, a composition of the individual parts of a particular factor should perform better than the average of the components. Here again, the study shows that returns for a given factor should be superior to a simple average of its constituting metrics.

The turnover for the factor strategies analyzed in the study is only slightly higher than the parent universe’s, the authors added. The tracking error is modest, so portfolio managers should be comfortable with the risk implications of these products, they said. 

Changing landscape

The construction of smart factor portfolios is of key importance in an increasingly competitive performance landscape. At the same time, the portfolios have become more attractive with decreasing management fees and transaction costs, while modern tools allow multifactor portfolio construction to target highly specific objectives. 

We invite you to download the article and explore the study’s findings.  

^[1] The multifactor signal was designed as 36% Quality, 27% Momentum, 27% Value, 5% Small Size, and 5% Low Risk.

• ISS STOXX^® Developed World Biodiversity Focus SRI
• ISS STOXX^® Europe 600 Biodiversity Focus SRI
• ISS STOXX^® US Biodiversity Focus SRI

Watch Michael Lewis, Head of Research for ESG at DWS, Hernando Cortina, Head of Index Strategy at ISS ESG, and Antonio Celeste, Director for Sustainable Product Management at STOXX, as they discuss the significance of biodiversity, and the tools to capture natural impact in both corporate and investment strategies.

This video first appeared on Asset TV’s “Integrating Biodiversity Considerations in Portfolios”.

A new whitepaper^[1] from ISS LiquidMetrix and STOXX seeks to answer this question by analyzing the trading costs involved in such a shift. The authors consider the cost of moving a standard holding of European equities as defined by the STOXX^® Europe 600 to two versions of the index that comply with the European Union Climate Benchmarks regulation: the STOXX^® Europe 600 Paris-Aligned Benchmark (“PAB”) and the STOXX^® Europe 600 Climate Transition Benchmark (“CTB”). 

CTBs and PABs follow EU provisions in terms of decarbonization trajectory, activity exclusions and sector exposure constraints. The two benchmark types differ in their level of restrictiveness and ambition. CTBs form a portfolio that is on a decarbonization trajectory, while PABs incorporate more stringent carbon limitations (“darker green”) that are in line with Paris Agreement global warming commitments.

In order to have a reference for a ‘typical’ (non-green) transition, the analysts also measure the cost of moving the benchmark to another standard index: the STOXX^® Developed Europe.

The authors compare the cost of transitioning a EUR 3.5-billion portfolio to the three alternative variants, with four trading strategies at different degrees of aggressiveness: trading the transition at 5%, 10%, and 20% market participation rates^[2], as well as using a full-day volume-weighted average price (VWAP) trading strategy. The ISS LiquidMetrix Pre-Trade Cost Estimate model^[3] is used to forecast the costs.

The cost of transitioning: impact and risk

The estimated trading cost is made up of two components: impact and risk cost. Impact is the cost associated with aggressive trading, crossing the market spread to secure the shares, and thereby raising the price. The more aggressive the trading (a higher participation rate) the greater the impact cost. The risk cost, meanwhile, is the cost from the price moving away. The longer it takes to complete the order (a more passive, smaller market participation rate), the higher the cost associated with risk.

Figure 1 from the whitepaper shows the analysis’ results. The composition of the total cost varies significantly depending on how aggressive the trading strategy is. Similarly, the weight of the components of implementation costs (impact + risk) vary.

While an ultra-passive 5% participation trading strategy provides lower impact costs, it carries a greater risk cost associated with overnight price movements. Conversely, a 20% participation strategy has a large impact cost but a lower associated risk cost as the time needed to complete the order is less.

Figure 1: Trading Cost Overview 

_{Source: ISS LiquidMetrix, STOXX.}

Overall, the 10% market participation strategy provides the lowest cost for implementing all three target portfolios, and the 5% participation the highest.

Comparing costs

A key conclusion is that transitioning to a green index portfolio is generally more expensive — between 15% and 20% more — than moving to a similar reference portfolio (i.e., the Developed Europe index). However, there is little difference in transition costs between a “green” versus a “greener” portfolio — stimulating potential moves to the latter. The exception happens when implementing an ultra-aggressive 20% participation strategy, where there is only a slightly higher cost in moving to a PAB rather than a CTB portfolio. 

Interestingly, using a 5% market participation trading strategy, the costs of transitioning to the “green” or “greener” portfolio are less than the cost of the reference transition. While the impact of trading passively is similar for all three benchmark indices, there is more price volatility risk in the Developed Europe portfolio. 

Cost vs. exposure comparison

Further, the authors also look at the cost of transitioning vs. the level of “green” exposure obtained, another factor to be considered when determining the rationale of shifting portfolios. 

For example, transitioning from the STOXX Europe 600 benchmark to a “greener” PAB portfolio at a 10% market participation strategy, generates a marginal cost of 7 basis points, or 6%, relative to transitioning to the “green” CTB benchmark. This additional cost, however, is accompanied by a further 14% reduction in climate emissions intensity relative to the benchmark.

The importance of transaction costs

With sustainable investing moving mainstream in Europe and elsewhere, a lot has been written about the tradeoffs investors need to consider when shifting to a climate policy. Much of this literature, however, has been focused on investment risk and exposures. The latest whitepaper, on the other hand, turns the attention to transaction costs.

“Transaction cost analysis is a critical part of any transition planning,” the publication’s authors write. “There are unique insights, however, that can be drawn from incorporating a cost-aware view among traditional risk/exposure analyses. Our case study highlights the potential cost efficiency of darker green portfolios, which also varies depending on the trading method chosen.”

The combination of unique datasets, portfolio construction techniques and analytics is at the heart of many recent innovations in financial services, the authors add. With those tools at hand, investors can make better-informed decisions when shifting strategies.